Cryptocurrency Derivatives Trading 101: Everything You Need to Know

Cryptocurrency trading is simply the buying, selling, and exchange of crypto assets in the hopes of profiting from the price volatility and arbitrage opportunities in the market. The fact that cryptocurrencies deliver exponential gains (during bull runs), which dwarfs the performance of other assets such as stocks is one of the reasons cryptocurrency trading is becoming popular.

However, cryptocurrency derivatives are gradually being adopted by traders because of the leverage that they deliver. Cryptocurrency derivatives provide an opportunity to profit from either the uptrend or downtrend in the price of cryptocurrencies without requiring you to buy, own, or hold the cryptocurrencies. Cryptocurrency market analysts often use the terms "Shorts' and "Longs" to refer to traders who are betting on the bearish or bullish prospects of the crypto market.

This piece is a practical guide for understanding how to take part in the cryptocurrency derivatives trading industry.

What are Cryptocurrency Derivatives?

Cryptocurrency derivatives are trading instruments that derive (the reason behind the name) their value from an underlying cryptocurrency or basket of cryptocurrencies. Fundamentally, cryptocurrency derivatives are built on an agreement between two counterparties to buy or sell a certain amount of a specified cryptocurrency at a pre-defined price on an agreed date in the future. The more important point to note, however, is that the value of a derivative instrument is often a function of the price of the underlying crypto asset.

Some types of cryptocurrency derivatives include:

Swaps

A derivative instrument that allows counterparties to exchange one cryptocurrency for another at a pre-defined rate sometime later, irrespective of the prevailing exchange rate when the swap is executed. For instance, if the BTC/ETH rate today is 1:50; a 3-months swap contract obligates the counterparties to trade Bitcoin for Ethereum at the same rate irrespective of the new market rate.

Futures

A futures contract gives the buyer the right and the obligation to buy a cryptocurrency, and it gives the seller the right and obligation to sell a cryptocurrency at a given price by a future date.

Options

An options contract gives the buyer the right (but without any obligation) to purchase a cryptocurrency, and it gives a seller the right (but without any obligation) to sell a given cryptocurrency at an agreed price by a given date.

Some other cryptocurrencies derivatives pending regulatory approval in different jurisdictions include crypto ETFs and crypto indexes.

Why do People Trade Crypto Derivatives?

Cryptocurrency trading is fundamentally different from trading traditional assets such as equities or forex. Derivatives add an extra layer of complexity to the highly volatile nature of regular cryptocurrency trading.

Speculation

The first reason people trade crypto derivatives is simply to make speculative trades. Volatile assets with fast-changing prices provide an opportunity for profit. Derivatives double the opportunity for speculative profit by allowing traders to make money when the asset is trading up (long) or when the cryptocurrency is trading down (short).

Hedging

Some traders (institutional traders especially) and investors use crypto derivatives to hedge their positions in other cryptocurrency holdings. Since derivatives provide leverage, a fraction of the future potential gain in a trade can be used to purchase a contract, which then provides an "insurance" of sort for capital preservation in case the trade goes south.

Leverage

Crypto derivatives provide an opportunity to apply leverage in trading decisions to unlock bigger profits. Instead of buying 1 BTC for $10,000; a 10X leverage could give you a position worth $100,000 equaling 10 BTC. Hence, your profit in the trade will be the equivalent profit of owning 10 BTC instead of the 1 BTC that you wanted to buy originally.

How to Trade Crypto Derivatives

Register on a crypto derivatives trading platform

Many cryptocurrency exchanges offer margin or leveraged trading. However, you'll have a better experience if you make regular cryptocurrency trades on the usual crypto exchanges while trading crypto derivates on platforms built exclusively for cryptocurrency derivatives trading.

Bybit is one of the few cryptocurrency derivatives trading platforms in the market, and its exclusive focus on derivatives enables it to offer features that are unmatched by regular exchanges. The sign-up process is easy, starting with your email address, and its tiered registration and verification structure ensure that you can start trading within a minute.

Fund your trading account

After creating an account, you can go ahead to fund it by depositing BTC, ETH, EOS, or XRP into the corresponding wallet in your account. There are no deposit fees beyond the usual network fees charged on the blockchain of each coin.

Start trading

Once your account is funded, you can begin trading as seen in the screenshot below. In the top left pane (red) you can choose the amount of leverage (multiplier effect) that you want. Bybit gives traders up to 100X leverage on their trades.

The middle left pane (blue) is where you enter how much money you want to commit to the trade. The amount entered here will be multiplied by the leverage.

The twin panes "Buy" and "Sell" holds the last step to activate your trade. You can hit the "Buy" button for a long position if you believe that the price of the underlying asset is set to increase.

You will hit the "Sell" button for the short position if you believe that the price of the underlying cryptocurrency will fall.

After you've placed your trade, you can look towards the bottom of the page for the pane named "Contract Details", which presents a one-glance snapshot of your position and the general state of the market.

The pane named "Positions" under the trading chart holds live market information about your trade, and it also helps you to know if the trade is making a profit or otherwise.

How Big is the Crypto Derivative Market?

On Wall Street where stocks and other traditional assets are traded, the size of the derivatives market is several times bigger than the size of the regular equities market. The cryptocurrency derivatives market is growing very fast especially because traders can trade and profit both in bull and bear markets. In Q1 2019, cryptocurrency derivatives trades were valued at $2.5 trillion while the value of coin-to-coin and fiat-to-coin trades were valued at $4.5 trillion.

As the cryptocurrency market continues to mature, the market for crypto derivatives will eventually catch up with regular crypto trades. You can expect that the market for derivative crypto trades will eventually outpace the market for regular crypto trades.

The Role of Regulation in Trading Crypto Derivatives

Cryptocurrency derivatives are permitted within regulatory frameworks across different jurisdictions. Bitcoin futures were the first kind of cryptocurrency derivatives allowed on regulated exchanges. Cryptocurrency swaps and options have also become a regular fixture in the crypto trading market.

However, in the U.S, the SEC has refused to approve multiple applications by different promoters that wanted to launch Bitcoin ETFs. The SEC contends that the cryptocurrency market doesn't yet have enough liquidity on which cryptocurrency ETFs can be built. It would be interesting to see how the regulations continue to play out in the next few years.